2, MULTIPLE GOALS IN CAPITAL BUDGETING AND FINANCIAL PLANNING 2.1, Introduction In this study we consider capital budgeting and financial planning as decision problens involving miltiple goals. In this chapter we will explain why. Among other things, we will argue that both the goal and the constraints used in the ‘traditional’ approaches to capital budgeting and financial planning should both be treated as goals, which can be traded off against each other. In the following chapters we will develop a normative framework for dealing with capital budgeting and financial planning models with multiple goals. "capital budgeting is concerned with the allocation of the firm's scarce resources among the available investment opportunities’, (Philippatos [ 1973, p.66]). The evaluation of investment opportunities within the capital budgeting process involves the consideration of the immediate and future cash flous implied by the investments. ‘Throughout this study we assume C,,, the cash flow in period t(t#1,.../7) associated with project i(i=1,...,n), to be concentrated at the end of period t. Thus we assure discrete instead of continuous tine. A positive sign of C,, denotes a oash inflow, a nenative sign a cash owtftem, ALL cash flows are assured to be determined according to the 'vith-orvithout" principle, implying that the cash flows represent the incremental effects of the project on the quality of the owners’ income over time. This is to take account of the possible interdependency between projects. Generally, a distinction is made between economie and stochastie dependence. Foonomie dependence occurs if the mere acceptance of one project influences the cash flows of another project. A special case is offered by mitually exclusive projects, which means that the acceptance of one project. 10prohibits the other project's acceptance. Two projects are said to be stochastically dependent 1f the covariance between their respective cash flows is non-zero. In reality, all conceivable combinations of economic with stochastic dependence may occur. Given these definitions, the market value of a project can be epressed as a function of the cash flows (including the initial investment outlays) associated with the project. For example, the net present value of project i may be defined as (2.1) Cog where Y,, represents the net present value of one dollar of the cash flow C4 Financial planning can be seen as an extended capital buigeting Problem, In financial planning, the investment opportunities are considered similtaneously with the financing and dividend options available to the firm (see e.g. Myers and Pogue [1974]). An important assumption made in the Literature on capital budgeting and financial planning is that the firm tries to maximize its owmers' wealth. Because this wealth is co-detemmined by the xisk-retum charasteristics if the incane streans generated by the fim, both 'risk' (bad: to be minimized) and ‘expected return! (good: to be maximized) are often taken as separate goals in the evaluation of capital investment projects. Assuming an efficient capital market, these goals can be replaced by a single goal, i.e. the ' firm's market value' (to be maximized), which leaves a single criterion decision problem. Goals however, other than those mentioned above, may also influence decisions concerning the selection of investment projects. As will be shown in this chapter, both the public and the private enterprise have to deal with a complex of multiple goals which 1changes over time. Tt will not always be possible to bring these multiple goals back to one single goal. In consequence, project selection might be seen as a decision problem involving miltiple goals. In spite of these possible arguments to treat capital budgeting and financial planning as multiple criteria decision problens, they are generally discussed in the Literature as being single criterion Gecision problems. However, the single criterion concerned (very often the fim's market value) is optimized subject to a set of constraints, part of which relates to managerial choices which night just as well be considered as separate goals. Therefore, we will discuss the nature of these constraints used in capital budgeting and financial planning in more detail in the following section. In this section, we will give a more precise meaning of the concepts of ‘goal’ and ‘constraint', as used in this study. The word goa? very often denotes a more or less detailed description of a desired situation to be strived for by an individual (or group of individuals), by (or for) whom this goal has been formulated. Exemples are the desire to ‘maximize profits’ and the desixe to ‘maintain the current level of employment', In our opinion, ‘one should distinguish between the object and the nature of a goal. By the object of a goal we mean the entity that is being strived for. ‘Thus in the above examples the objects are 'profits' and the 'level of enploynent' respectively. The object of a goal is a variable, referred to as a goal variable (see also Section 3.1). The nature of a goal indicates what the decision maker wants with the object at hand, e.g. in the case of the goal variable ‘profits’, should it be maximized, minimized, or should a certain minimm level be strived for? IE goals are to be mandatory for the determination of the action +0 be chosen, a more or less clear relationship between the dbject of the goal and the altemative actions should be definable (see Section 3.1). In our opinion, if such a relationship can (in principle) not 12